Beijing is not Washington’s banker

Michael Pettis really gets at the heart of the fallacious argument that China is somehow bankrolling the United States government. The fact is the Chinese have fixed their currency at an exchange rate which induces a current account surplus with the U.S. and…

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit. And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets. Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why? Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price. What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price. That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market. Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

So the only question for China is which U.S. dollar assets it will buy, not whether it will go on a U.S. dollar strike. Of course, the Chinese could revalue as the Obama Administration is pressuring them to do. However, if the Chinese did significantly revalue their currency and pegged it at a higher rate, that sucking noise you would hear would be jobs leaving the overcapacity-riddled Chinese domestic economy.

The China-as-Washington’s-banker stuff does make for good laughs on Saturday Night Live. But, it is bogus economics. The next time you hear these arguments you will know why.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

If the Chinese let the renminbi float, it would most likely appreciate tremendously. This would crush the Chinese domestic economy because of all the excess capacity they have built. As a result, they will keep pushing it up modestly at best.